On March 29, 2011, the Fourth Circuit rendered its opinion in Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, No. 10-1333 (opinion linked below). As described in our previous coverage, the case involved an IRS challenge to the taxpayer’s treatment of partnerships used as marketing vehicles for state tax credits derived from historic rehabilitation projects. Agreeing with the government’s disguised sale theory, the court reversed the Tax Court and ruled that the transactions at issue were taxable sales of state tax credits, as opposed to non-taxable capital contributions followed by partnership distributions.

After quickly dispensing with the taxpayer’s argument that the tax credits received by investors were not “property” under the statute, and skipping over the question of whether the funds’ investors were bona fide partners for federal tax purposes, the court took a decidedly statutory approach to resolving the case by focusing on the disguised sale regime under I.R.C. § 707(b). In applying the statute, the court largely relied on the guidance in Treas. Reg. § 1.707-3, which sets forth a presumption that reciprocal transfers between a partner and a partnership within a two-year period constitute a disguised sale unless facts and circumstances clearly establish otherwise. The regulation also lists ten factors to consider in determining whether the second transfer in a non-simultaneous pair of transfers is “dependent on the entrepreneurial risks of partnership operations.”

In addition to finding that the transfers-within-two-years presumption required the taxpayer to “clearly establish” that the transfers did not constitute a sale, the court focused on five of the Treas. Reg. § 1.707-3 factors. First, the court found the timing and amount of the second transfer (the allocation of tax credits to the investors) were determinable with reasonable certainty at the time of the first transfer (the alleged contributions to capital made by the investors), and each investor knew with specificity the size of the credits that he or she could expect. Second, the investors had legally enforceable rights to the credits per their subscription agreements; they had been promised state credits in exchange for their capital contributions. Third, the investors’ rights to the credits were secured through a promise of refunds if sufficient state credits were not delivered to the investors. Fourth, the transfers of credits to the investors were disproportionately large compared to the negligible (0.01 percent) interest that most investors held in the partnerships. Significantly, in this regard the court found that “the transfer of tax credits to each investor by the partnership had no correlation to each investor’s interest in partnership profits whatsoever.” Finally, the investors had no further obligations or relationship with the partnership after they received their credits. In light of the presumption, the court opined that these factors “strongly counsel for a finding that these transactions were sales.”

Further girding its rationale, the court noted that the taxpayer did not follow the form of the subscription agreements, assigning each investor a 0.01 percent interest regardless of their capital contributions. The Fourth Circuit further noted that the partnership status of the investors was transitory in nature, which echoed a concern expressed in the legislative history to section 707(b). Also, the court noted that the Tax Court did not analyze the factors in Treas. Reg. § 1.707-3 but rather relied on its own analysis of the investors’ level of entrepreneurial risk. As an interesting aside (from a regulatory deference point of view), the court opined that the Tax Court was not bound to “tick through [the factors] mechanically[,]” but was “free to” conduct its own evaluation of risk, because the regulation “simply reflects those characteristics the Department of the Treasury, given its experience and expertise, thinks significant.” Nonetheless, the court found the Tax Court’s independent analysis of entrepreneurial risk unconvincing, viewing the risks cited as “both speculative and circumscribed.” In the final analysis, the court held that the only risk borne by the investors was “that faced by any advance purchaser who pays for an item with a promise of later delivery. It is not the risk of the entrepreneur who puts money into a venture with the hope that it might grow in amount but with the knowledge that it may well shrink.”

As promised, the government filed a petition for rehearing en banc in the Fifth Circuit in the Burks case. The filing has one wrinkle that differs from the numerous other recent filings on this issue. The petition claims an intracircuit conflict as a basis for rehearing en banc, arguing that the panel’s decision conflicts with Phinney v. Chambers, 392 F.2d 680 (5th Cir. 1968), a case that the panel had found distinguishable. See our previous report on the Burks decision here.

As we have reported extensively (e.g. here and here), the courts of appeals appear to be hopelessly split on the “Intermountain” issue of whether a six-year statute of limitations applies to overstatements of basis. Nevertheless, the government has not given up on the possibility of winning this issue in all courts of appeals and thus eliminating the need for it to go to the Supreme Court. To that end, it filed in two cases at the rehearing stage yesterday.

In the Beard case in the Seventh Circuit, the government filed a response opposing the taxpayer’s petition for rehearing en banc. It argued that the Seventh Circuit’s pro-government decision was correct and pointed out that the Seventh Circuit “cannot by itself resolve this conflict” in the circuits even if it grants rehearing, because there are multiple circuits that have ruled on both sides of the issue.

In the Home Concrete case in the Fourth Circuit, the government filed its own petition for rehearing en banc. It argued that the Fourth Circuit erred and should instead adopt the reasoning of either the Seventh Circuit in Beard or the Federal Circuit in Grapevine. Lawyers being what they are, the government’s own petition managed to avoid pointing out to the Fourth Circuit that it “cannot by itself resolve this conflict.” The petition did state that the government also plans to seek rehearing in the next few days in the Burks case in Fifth Circuit — the other court of appeals that has rejected the government’s position even after the new regulations issued.

For now, these filings seem to put the Beard case back in the lead as the first case likely to be ready for Supreme Court review. But that can change depending on the respective speed with which the different courts of appeals rule on the rehearing petitions.

A while ago we reported on a spate of IRS successes in cases involving purported securities loans (here). The Samueli case is fully briefed in the Ninth Circuit and is expected to be argued in the next couple of months. As we anticipated, two more of those cases, Anschutz and Calloway, have been appealed to the Tenth and Eleventh Circuits, respectively. The taxpayer in Calloway filed his opening brief on March 15, 2011 (linked below). Briefing has not yet begun in Anschutz.

In Calloway, the taxpayer was an IBM employee of many years who had acquired IBM stock during his employment. By the time of the transaction in question, the stock’s value was five times the taxpayer’s basis. Desiring to monetize the stock, and by his own admission, seeking to maximize his after-tax return, the taxpayer entered into an arrangement whereby he transferred his stock to a counterparty in return for a loan equal to 90% of the stock’s fair market value. This resulted in a 10% higher return than a straight sale subject to long-term capital gains tax. Under the arrangement, the taxpayer had no right to any dividends, no ability to reap any gains from appreciation of the stock, and no right to recall the stock during the loan period. The counterparty had the right to sell or otherwise dispose of the stock it purportedly held as collateral. At the close of the three-year loan period, the taxpayer had the option of repaying the principal with interest to redeem his collateral, refinancing the transaction for an additional term, or surrendering his collateral in exchange for extinguishment of the debt. As the stock had depreciated significantly, the taxpayer chose to surrender his collateral. Notably, not only did the taxpayer not report the transaction as a sale, he also did not report any cancellation of indebtedness income upon extinguishing the purported debt.

The IRS challenged the taxpayer’s treatment of the transaction as a loan, asserting that in substance the arrangement was a sale of the taxpayer’s securities. In a reviewed decision, the Tax Court agreed with the IRS that the transaction was indeed a sale, primarily because the benefits and burdens of ownership of the stock had in fact passed to the counterparty (under an application of the test articulated in Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981)). Of course, it didn’t help the taxpayer that the counterparty had been sued successfully for promoter penalties and for an injunction to cease all further shelter promotion activities.

On appeal, the taxpayer’s position centers around the arguments that (1) the Tax Court’s finding that the counterparty had the right to sell the stock immediately was clear error, and (2) the finding that the taxpayer could not demand the return of his stock during the three-year period was also clear error. These arguments apparently are based on the position that the counterparty did not have the right to sell the stock until a “legitimate” loan was already in place, and because the counterparty used the stock sale to finance the purported loan, no such right ever accrued. Thus, according to the taxpayer, he remained in control of the stock under the terms of the arrangement, and therefore the transaction is subject to the safe harbors under I.R.C. § 1058 and Rev. Rul. 57-451, and furthermore should not be deemed a sale under the applicable common law securities-loan authorities.

We’ll provide an update when the government files its response, and we’ll post on Anschutz when the briefing gets under way (the opening brief is due May 2). On a related note, the Tax Court recently held for the government in a case involving a transaction materially identical to the one in Calloway. See Kurata v. Commissioner, T.C. Memo 2011-64 (March 16, 2011).

As we have previously reported, the Third Circuit is considering a tricky issue relating to the Tax Court’s jurisdiction to resolve disputes concerning overpayment interest. At the oral argument, the court explored different facets of the issue, even while joking about its complexity. At one point, one of the judges appeared to question whether the Tax Court’s Estate of Baumgardner case was correctly decided, even though the IRS had acqueisced in it. Government counsel declined that offer, instead adhering to the view that Baumgardner is different because it involved deficiency interest rather than overpayment interest. Taxpayer’s counsel invoked Code section 7481(c) as a possible alternative jurisdictional basis for the Tax Court, but the government responded that section 7481(c) could not apply to Sunoco’s situation. In response to a question, government counsel acknowledged that the dispute in Sunoco would not affect many taxpayers, as they usually bring overpayment interest claims to the Court of Federal Claims.

Although no precise consensus emerged from the court’s questions and answers, the panel seemed to exhibit sufficient skepticism about the Tax Court’s reasoning that practitioners should be cautious in placing much weight on the Tax Court’s decision. There is certainly a substantial risk that it will be reversed.

The Second Circuit has announced a May 16 oral argument date in TIFD III-E, Inc. v. United States, which is the second go-round for the case better known as Castle Harbour after the district court ruled again for the taxpayer on remand from the Second Circuit’s previous reversal. (See our prior reports and the briefs here, here, and here.) The identity of the three-judge panel will not be revealed until a later date.

On March 7, the taxpayer filed a petition for rehearing en banc (attached below) with the Seventh Circuit in Beard, emphasizing that both the Fifth and Fourth Circuits had explicitly disagreed with that decision and reached the opposite result on the Intermountain issue. Although courts of appeals often deny such petitions without a response, the Seventh Circuit almost immediately directed the government to file a response, which is due March 23. Today’s pro-government decision by the Federal Circuit in Grapevine perhaps takes a little steam out of the possibility of rehearing since a circuit conflict will likely persist even if the Seventh Circuit rehears the case and reverses itself, but the full Seventh Circuit still may want to consider whether the panel had a sound basis for disagreeing with so many other courts. The Grapevine decision, of course, rests on a different ground from Beard — namely, deference to the new regulations. With respect to the statutory issue addressed by the Beard panel, the Federal Circuit also is in disagreement with the Seventh Circuit.

The Federal Circuit has ruled for the government in Grapevine, throwing the circuits into further disarray by adopting an approach that differs from all three of the courts of appeals that have previously addressed the Intermountain issue subsequent to the issuance of the new regulations. Because the Federal Circuit had already rejected the government’s construction of the statute in Salman Ranch, the Grapevine case starkly posed the question whether the new regulations had the effect of requiring the court to disregard its prior decision and reach the opposite result. As we previously reported, at oral argument the day after the decision in Mayo Foundation, the government told the Federal Circuit that Mayo compelled that result. The court has now agreed.

A key section of the court’s opinion considers whether the Supreme Court’s decision in Colony defeats the government’s deference argument. The court says it does not because Colony itself stated that it did not regard the statutory text as unambiguous and, even considering the Colony court’s review of the legislative history, the court did not believe that “Congress’s intent was so clear that no reasonable interpretation could differ.” Therefore, Colony did not resolve the case under Chevron Step 1 and,under Brand X, Treasury was free to issue a regulation that contradicts Colony. (In its analysis, the Federal Circuit appears to have sided with the view, based on footnote 9 of Chevron, that legislative history can be considered at Chevron Step 1 (see our previous post)). The court then applies the Chevron analysis to the new regulations and concludes that they are reasonable based on exactly the same government arguments that the court rejected in Salman Ranch when it was construing the statute in the absence of a regulation. Finally, the court rules that Treasury did not abuse its discretion in applying the new regulations retroactively to years that were still open under the six-year statute.

The Grapevine decision is significant in the specific context of the Intermountain cases, as it virtually ensures that a circuit conflict on the issue will persist even if the Seventh Circuit reconsiders its decision in Beard. And it is the first appellate decision to address in detail the merits of the government’s primary argument that it can overturn the prior adverse decisions in this area by regulation. More generally, the case is a great illustration of Treasury’s power under the combination of Mayo and Brand X. The Federal Circuit was keenly aware of the implications of its decision, summarizing it as follows: “This case highlights the extent of the Treasury Department’s authority over the Tax Code. As Chevron and Brand X illustrate, Congress has the power to give regulatory agencies, not the courts, primary responsibility to interpret ambiguous statutory provisions.” Presumably, Treasury will continue to test the limits of how far it can go in exercising that “primary responsibility.”

The Third Circuit has now issued a briefing schedule in the PPL case that makes the government’s opening brief due on April 5. This schedule should have the case marching along in fairly close parallel with Entergy, the companion case presenting the same UK tax creditability issue to the Fifth Circuit. (See our previous post here.) In Entergy, the government recently requested an extension to file its opening brief. The court granted an extension, but for less time than requested. The brief is now due April 13, after a 30-day extension. That date will likely hold, since the court has already cut back an unopposed extension request. In PPL, by contrast, it is quite possible that the government will get some additional time.

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The Tax Appellate Blog is intended to be a resource for information on important tax cases under consideration in the appellate courts. It will feature insightful commentary on the issues and provide a dedicated site for following the progress of these cases.

Authors

Steve Dixon is a Member in the Tax Department at Miller & Chevalier. He specializes in controversy and litigation, representing taxpayers in the Tax Court and Federal courts.

Laura Ferguson is a Member of the Supreme Court and Appellate Litigation Group at Miller & Chevalier and has successfully briefed and argued six cases at the U.S. Courts of Appeals in the past two years. Ms. Ferguson also has extensive experience litigating complex, high-stakes tax cases at the Tax Court and federal district courts.

Alan Horowitz is the former Tax Assistant to the Solicitor General at the Department of Justice, where he briefed and argued numerous tax cases in the Supreme Court. He is currently the head of the Supreme Court and Appellate Litigation Group at Miller & Chevalier.